IN THIS EDITION
•GUESS WHAT’S COMING TO DINNER: INFLATION! The surge in global food prices will soon arrive on the dinner table. However, to focus on the direct inflationary impact of higher food prices alone is to miss the bigger, far more inflationary picture implied by rising wage demands in developing countries. Beginning next year, consumers in most developed economies will discover to their surprise that “food” price inflation is creeping into an astonishingly wide variety of consumer goods.
•FROM STAGNATION TO STAGFLATION: US CPI has been trending lower amidst a stagnating US economy. However, a look behind the headline economic data and across some financial market developments reveals a disturbing picture, that in fact the US economy may already have entered a “stagflationary” situation not unlike the late 1970s. This spells danger for financial asset prices.
GUESS WHAT’S COMING TO DINNER: INFLATION!
The US Bureau of Labor Statistics (BLS) recently reported that consumer price inflation (CPI) declined in September to a 59-year low of just 1.1% y/y. Excluding more volatile food and energy prices, the so-called core CPI rose only 0.8% y/y. This is not good news for the US Federal Reserve, which considers this a dangerously low rate of CPI. While the Fed lacks a formal CPI target–unlike many other central banks–it nevertheless seeks to keep inflation sufficiently above zero so that, should the economy weaken further, low inflation is unlikely to turn into outright deflation, something the Fed considers it necessary to avoid at all costs.1
With a range of economic indicators now suggesting that the rate of US economic growth has moderated of late, the Fed is preparing to add additional monetary stimulus to the economy, most probably in the form of expanded US Treasury purchases. This, the Fed appears to believe, will lower borrowing costs and perhaps further weaken the dollar somewhat. That in turn should stimulate economic activity such that the risks of consumer price deflation diminish.
Now the Fed is not necessarily highly confident at this point that this is going to work. Indeed, there is an unusually large amount of dissent at the Fed at present. A number of senior Fed officials–most notably Thomas Hoenig, President of the Kansas City Fed–are sceptical that additional monetary stimulus will have the desired effect on the economy and, in fact, might be counterproductive.2
Why might additional stimulus be ineffective? After all, the Fed has a long track record of injecting monetary stimulus into the economy from time to time, supporting growth and preventing deflation. Indeed, as observed above, there has been no consumer price deflation in the US for two full generations, and no severe, prolonged deflation since 1934.3
Well there are signs that Fed stimulus to date is not having much effect. Notwithstanding near zero policy rates and a doubling of the monetary base, the economy is clearly struggling and CPI has continued to trend lower amidst spare capacity in many business sectors. With broad un- and under-employment currently at 17%, most US workers are not in a position to demand higher wages as firms seek ways to maintain profit margins amidst weak final demand. (Real final sales, which subtracts changes in inventories from GDP and thus is a more stable measure of economic activity, has grown at a mere 1% over the past two quarters.) The employment cost index (ECI), which measures the rate of growth of total compensation–wages and benefits–has risen a mere 1.8% over the past year, far below the 3-4% average of the past decade and barely above the 1.1% rate of CPI y/y. Until un- and under-employment declines substantially, additional money flooding into the financial system is unlikely to have much if any impact on wages and, hence, is unlikely to contribute, at least not directly, to a rise in CPI.
But what about growth? Won’t additional money creation stimulate business investment, eventually supporting the job market, wages and consumption, thereby pushing up CPI? Well that is certainly what the Fed would like to see, but with both business and consumer confidence extremely weak, it is far from clear that any additional money created will do anything other than push up banks’ so-called “excess reserves”, that is, money which the Fed has made available to the banks but which they have chosen not to lend out in some form.
Many refer to this sort of situation as a Keynesian “liquidity trap”. You can lead the horse to water (liquidity) but you can’t make it drink (borrow/invest/spend). Keynes’ solution to this problem was for fiscal policy to go where monetary cannot, which is to force additional spending, either indirectly, via a debt-financed tax cut or, directly, through increased government spending. The former can be considered “supply-side” and the latter “demand-side” forms of stimulus but from a broad macroeconomic perspective they amount to much the same thing: Both are, in effect, attempts to spend one’s way out of an economic downturn brought about by excessive debt and financial leverage. The effects of such policies might look nice on the aggregate income statement for a time–in that economic activity remains artificially elevated–but the aggregate balance sheet is going to deteriorate as a result. And as any good financial analyst knows: The income statement is the past. The balance sheet is the future.4
A deteriorating balance sheet, or expectations thereof, normally would lead financial markets to demand a higher risk premium to hold a company’s stock, which implies a lower price-to-earnings (P/E) ratio. This can come about, however, either through a decline in the price of the stock, an increase in the earnings yield, or some combination thereof. In the event of sovereign balance sheet deterioration, however, as described above, there is no “stock” per se, but there is a yield on a government bond. If global investors observe a deteriorating sovereign “balance sheet”, they will demand a higher yield premium to hold that bond relative to some other asset. As the yield rises, the price of the bond declines, in effect devaluing the debt and reducing the “P/E ratio”. But then what happens when the central bank resists a rise (or facilitates a decline) in bond yields by lowering policy rates or buys up bonds directly in permanent open market operations (POMOs), as the Fed is now doing?
In this case, the required adjustment cannot fully take place via a higher bond yield, so instead, the price of the bond must decline in real rather than nominal terms. For this to happen, the currency must decline. It is no coincidence that, as the Fed has made it increasingly clear to financial markets that it is prepared, in principle, to expand the POMO programme indefinitely until inflation (or expectations thereof) rises by a desired amount, the dollar has declined sharply versus nearly all other currencies.
We have suggested in past Amphora Reports that the Fed’s eagerness to expand its current programme of POMO Treasury purchases–known in the contemporary financial jargon as QE2 for “quantitative easing round two”–is perhaps best explained by an ulterior motive, that is, to weaken the dollar, thereby facilitating the importation of inflation via higher import prices, including of course commodities but also other imported goods. Now the Fed would not and in fact legally can not seek to devalue the dollar, as US currency policy resides with the Treasury, not the Fed. But of course Fed policies can have a huge impact on the dollar and, as long as the Treasury does not oppose them, then for all practical purposes, the Fed implements currency policy. In the current instance, if the Fed is indeed seeking a weaker dollar, then the US is rightly considered to have a “weak dollar policy”, in sharp contrast to the “strong dollar policy” which was explicitly followed by the Clinton administration in the 1990s.5
This argument is not lost on certain foreign governments. China, Brazil and now also Germany see through the US Fed/Treasury smokescreen. Senior officials of all three countries are now accusing the US of currency manipulation via aggressive and unconventional monetary stimulus. From their perspective, they don’t care whether such policies are instigated by the supposedly independent Federal Reserve or by the US Treasury. The result is that the Fed, as the issuer of the global reserve currency, is flooding the global economy with liquidity. This is causing all sorts of economic mayhem around the world, ranging from asset bubbles associated with so-called “hot-money” foreign capital flows, to soaring consumer price inflation.
Yes, that’s right, soaring inflation. Perhaps not yet in the US, mind you, but elsewhere. Back in April, we explored the topic of rising inflationary pressures around the world and discovered that, just about everywhere, inflation rates were no longer declining and, in some cases, had already risen to levels associated with economic overheating. Now, six months later, with inflation already elevated, there is a major inflationary shock in the pipeline in the form of higher food and textile prices.
Although it may have started as a supply scare associated with widespread destruction by fire of the Russian wheat crop, prices for agricultural commodities, in particular grains, sugar and cotton, have soared over the past few months. Wheat and soyabeans are both up by over 30%. Corn by nearly 50%. Sugar by 65%. Coffee by over 30%. Cotton by 60%.
These are huge increases. There is no way that price rises of this magnitude are going to be absorbed by producers in the form of reduced profit margins. No, as the demand for food and basic clothing is highly price inelastic–that is, consumers don’t demand much less of it even in the event of a large rise in price–these increases are going to show up before long on the dinner table and in the wardrobe.
Now it might be the case that, in most developed economies, food comprises, on average, a small portion of the household budget. In the US, for example, the BLS estimates that it accounts for only 14% of median household expenditures (although food prices are generally lower in the US than in most developed economies for various reasons ranging from economies of scale to taxes). In any case, consider now that, say, only 25% of the recent, approximately 40% increase in a broad basket of basic foodstuff prices is passed through to consumers. Other factors equal, this implies that US CPI is going to rise by 40% * 25% * 14% or about 1.4%. But if 50% is passed through, this rises to 2.8%. If 75%, to 3.2%. Households will almost certainly notice, especially when these price increases are set alongside stagnant or possibly even declining wages. Nevertheless, a modest rise in the CPI, even amidst anaemic growth, would hardly compare to the 1970s, when the CPI reached double-digits and the word “stagflation” entered the economic lexicon.
But wait: The story does not end there. As mentioned above, the food price shock in developing economies is going to add fuel to their inflationary fires. Amidst healthy economic growth and low unemployment, workers in these more dynamic economies are already pushing for higher wages, sometimes in the form of disruptive and occasionally even violent strikes. Rising wage demands will, at the margin, result in higher production costs generally. Some portion of these costs are likely to be absorbed into corporate profit margins but, naturally, some will be passed on to consumers in the form of higher prices. Also, keep in mind that these dynamic developing economies are precisely those which export all manner of consumer goods to the developed economies, notably the US.
In this way, the US and other developed economies are poised to import food price inflation not only directly, in the form of sharply higher food prices, but also indirectly, in the form of higher imported goods prices generally. Textiles, furniture, hardware, appliances, electronics, toys–you name it–are produced in and thus imported from those very developing countries now facing sharply rising wage pressures. The global food price shock is thus going to become a general imported goods price shock, albeit with a longer time-lag of quarters rather than months.
Now this discussion of the potential for higher CPI in developed economies so far ignores the possibility that, in response to rising wages and inflation, China, India and perhaps other countries become willing to allow substantially more currency appreciation. Although this would hurt competitiveness, so will rising wages in time. And to the extent that these countries, notably China, are net food importers, stronger currencies will go right to the consumer’s bottom line in the form of improved food affordability. In this way, rather than endure wage disputes, labour strikes and other economically and potentially socially destabilising actions, countries like China could act pre-emptively to head off such threats. If they do, the rate at which the US and other developed economies import price inflation will be commensurately quicker.
Nevertheless, as discussed above, higher inflation is regarded by the US Fed and, tacitly at least by the US Treasury, as something to be encouraged rather that avoided. Presumably they would like nothing more than to see China and probably other countries allow additional currency strength versus the dollar. Remember, inflation of only 1% a year is somehow “dangerously low”–notwithstanding the fact that the US financial system almost collapsed amidst higher inflation. (As an aside, according to Orwellian Federal Reserve rhetoric, “price stability” is inflation of at least 2%.)
Following the financial crisis, it would be surprising had the Fed not lost some credibility. After all, they didn’t see the crisis coming and, arguably, their actions in the years 2004-07 contributed to it. Looking forward, if indeed the Fed is committed to engineering a modestly higher CPI, are financial markets pricing in such a development? Do they trust the Fed to achieve its policy objectives?
The most straightforward way to observe CPI expectations is by looking at the implied inflation rates embedded in the prices of inflation-linked securities, which in the US are known as TIPS. 10y TIPS prices currently imply a future inflation rate of around 2.5%, which is more or less in line with assumed Fed policy goals. As such, financial markets appear to be pricing in at present that the Fed is likely to succeed in restoring a low and stable rate of CPI in future. Yet this is a highly dangerous assumption, as demonstrated by our discussion of the coming food price shock, its impact on developing economies and the potential for the US to quite suddenly import a substantial amount of inflation from the rest of the world, either via higher world wages, a weaker dollar, or some combination thereof. We find it curious that financial markets seem to imply that the Fed can pull this off. Or do they? In the following section, we explore the possibility that the future inflation rates implied by TIPS are, in fact, dangerously misleading.
FROM STAGNATION TO STAGFLATION
With economic growth as measured by real final demand so weak, any increase in inflation which is not associated with a higher rate of real growth will represent a transition from the economic stagnation of the past few years to an even more unsatisfactory state of affairs, a dreaded “stagflation”, which came to plague the US and, to a lesser extent, global economy in the late 1970s. But wait, some might object, US CPI reached double-digits in the late 1970s/early 1980s, surely this is not a fair comparison? To which we reply: Good point. Let’s make certain that we are comparing like with like and adjust for changes that have been made to the CPI calculation methodology in the interim, as these have been substantial.
A respected independent economist, Mr John Williams, maintains an excellent website publishing what he has termed “Shadow Government Statistics”, which show how the economy is performing today, using statistical methodologies from the 1970s for GDP, CPI and so on.6 These statistics allow for a proper comparison of contemporary and past US economic data. The results are illuminating, to say the least. Whereas the official, current rate of CPI is at a “59-year low” 1.1% y/y, when applying the same statistical methodology that prevailed in the 1970s–comparing like with like–in fact US CPI is currently 8% y/y! 8%! And there is a substantial food and import price inflation shock about to arrive!
TIPS may not be pricing in 8% y/y inflation or higher, but why should they? They don’t pay the old CPI as a coupon, they pay the current CPI. As such, TIPS implied inflation rates simply can’t tell us that we are perhaps already deep into an economic stagflation comparable to the late 1970s!
For those sceptical that this is a legitimate line of inquiry, consider some ominous parallels between current financial market developments and those of the late 1970s:
- The dollar is weak nearly across the board;
- The gold price has soared to records;
- The prices of commodities generally are now also rising rapidly;
- The stock market is rising;
- Yet all of the above are occurring alongside generally weakening US leading economic indicators
The evidence strongly suggests that US CPI is not 1.1% y/y but rather somewhat higher. But if US CPI is in fact somewhat higher then this implies that the real rate of GDP growth is commensurately lower, as real growth = nominal growth - price inflation. Yet with official GDP growth as weak as it is, then that would imply that, in fact, true real GDP growth is outright negative. Impossible? Well, consider some other interesting economic facts:
- The economy is not adding jobs and, in fact, employment remains far below the peak reached in 2007;
- State sales tax revenue growth is negative, implying negative real retail sales growth;
- The Conference Board consumer survey of inflation expectations is around 5%
Isn’t it far, far easier to understand the behaviour of financial markets and the broader range of economic data hiding behind the headline figures, by assuming that CPI is somewhat higher, and real GDP growth somewhat lower, than official figures suggest? We leave it to the reader to decide.
If the real state of economic affairs in indeed as bad as Mr Williams’ data imply, then we are, in fact, already deep into a stagflation which is only going to get worse. The financial market implications are significant.
First of all, it is likely to become increasingly evident that current US bond yields are far too low to compensate investors for the increasingly rapid loss of purchasing power. As such, either yields are going to have to rise or, to the extent that the Fed stands in the way, the dollar decline.
Second, corporate profits are going to suffer in a severe squeeze between sharply rising input prices on the one hand and poor real final demand on the other. This is likely to weigh on equity markets although equities are likely to outperform bonds as corporations, in particular those producing/providing relatively non-discretionary goods and services, are able to pass on some costs to consumers.
Third, within equities, financial shares are likely to underperform, possibly dramatically. The more severe the stagflation becomes, the more likely that, eventually, interest rates are going to rise. While goods-producing firms able to export might benefit in time from a weaker dollar and lower relative wage costs, financials do not benefit directly from such developments. Rather, their valuations are a direct function of the level of interest rates.7 A glance at the relative performance of US financials during Fed Chairman Volcker’s 1979-82 assault on inflation, via higher interest rates, is instructive in this regard.
Fourth, commodities are likely to remain the best performing asset class. Gold and other precious metals may, or may not, lead the way, as their prices are already elevated relative to those for other commodities. Crucial here will be the perceived risk of the US financial system. If confidence in the financial system deteriorates substantially, precious metals are likely to be the best performers. If financial conditions are relatively stable, a more balanced and widespread outperformance of commodities becomes more likely.
Needless to say, this is not a benign investment environment. Those living on fixed incomes are going to see their purchasing power substantially eroded over time. Those who think that stocks are cheap due to highly misleading comparisons with the unsustainable asset bubbles of the past are going to be disappointed. Adding to the misery for stock market investors will be the “green-tape” associated with new environmental and natural resource regulations; a more aggressive regulatory regime generally; tremendous political and hence tax policy uncertainty; and an astonishingly widespread culture of corporate fraud, which has no doubt been substantially facilitated by the complete lack of even basic enforcement of US contract and securities laws before, during and following the financial crisis of 2008.
While the above comments are rather specific to the US, certain other developed economies, including parts of the euro-area, the UK and Japan, have issues which are in many cases similar and in some cases even worse. And while emerging markets are likely to continue to outperform on trend, at least in relative terms, investors should be cautious regardless of where they are looking for value around the world.
For those readers who have been following our reports, no doubt this edition represents another rather depressing instalment. We are long on criticism and rather short on proposed solutions. From time to time we do try to offer reasons for hope and, in this edition, we close with a few.
First, we note that alternative, non-Keynesian economic thinking is beginning to find its way into the mainstream press. Regular readers of the Wall Street Journal (US), Financial Times (UK) and Daily Telegraph (UK) have probably already noticed this. Policymakers are more likely to listen to these sorts of media sources than those of the blogosphere, however pertinent, sophisticated and credible the latter.
Second, economic policymakers in a growing number of countries, in particular in Europe but also in certain emerging markets, are beginning to take pro-active measures to place their economies on a more sustainable path, even if this places them in direct confrontation with the US. Germany is an important case in point, as are France, Brazil and India. We would even place the UK in this group.8
Third, some influential business leaders in the US are now speaking out against plans for additional stimulus, arguing instead that more fundamental economic restructuring is now necessary, however painful it might be in the near-term. This is a welcome contrast to the near universal acceptance of the business community back in 2008-09 that, without substantial fiscal and monetary stimulus, the US would somehow become an economic wasteland overnight.
Fourth, while we are not partisan in our politics, we welcome the growing political activism in the US, Europe and elsewhere. In all cases, there is much more citizen engagement and fundamental debate taking place around all manner of economic issues. While in certain cases demonstrations are turning violent, it is important to understand that this is an unfortunate symptom of supposedly representative political systems not living up to the spirit of their specific constitutions or of their democratic traditions generally. Long may the activism continue.
These are all important developments. The first step toward curing an addiction–in this case artificial, unsustainable and ultimately counterproductive economic stimulus–is to recognise it for what it is. As the media, policymakers, businessmen and all citizens wake up, the odds grow that we might just manage to avoid an even worse fate than that which already awaits us as the consequence of colossal past policy mistakes.
No, there is no easy way out. There is no free lunch. Indeed, that lunch is going to get much more expensive before long.
The Amphora Liquid Value Index (through 28 October 2010)
Source: Bloomberg LP
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1 The reasons why the Fed is so terrified of outright price deflation makes for an interesting topic in its own right. While it is not central to our discussion here, we find it curious that the Fed, which not only implements monetary policy but also regulates the banking system, continues to believe that price deflation is more dangerous than, say, excessive debt and financial leverage. After all, it is the latter, not the former, that nearly collapsed the entire US and possibly global financial system in 2008.
As an aside, The Fed refers to a rate of sufficiently high inflation as “price stability”. Now it may sound a bit Orwellian to equate sufficiently high inflation with price stability, but we must consider that the Fed is an authorised agency of the US government.
2 There are various ways in which Fed officials can dissent from official policy. The most formal is for those officials who sit on the Federal Open Markets Committee (FOMC) to cast a dissenting vote, as Kansas City Fed President Thomas Hoenig has been doing all year. However, as most regional Fed presidents do not vote at all FOMC meetings, they can also dissent by speaking out against official policy. Among those who have done so, in varying degrees, are regional Fed Presidents Fisher (Dallas), Kocherlakota (Minneapolis) and Lacker (Richmond). Recently retired St Louis Fed President Poole has also been critical of late.
3 We have made this point before but consider it so important we repeat it here: While the Great Depression (GD) continued through the entire decade of the 1930s, the data demonstrate that the deflation associated therewith came to an abrupt end in 1934, when FDR devalued the dollar. Thereafter, the price level remained generally stable. To us, this is clear evidence that, while the deflation may have been a symptom of the GD, it was not the cause. Had that been the case, then by ending the deflation the GD should also have ended.
4 The relative importance placed on the income statement relative to the balance sheet is perhaps the best way to understand the core of the debate between so-called “Keynesians” and so-called “Monetarists”. The former believe that the income statement is the key to a healthy balance sheet; the latter that a healthy balance sheet is the key to a healthy income statement. In a sense, both are right in that, over longer periods of time, you can’t have one without the other. However, in a much more important sense, they are both wrong, in that they believe that some form of stimulus, either fiscal or monetary, is the solution to weak aggregate demand resulting from previous, excessive stimulus. It doesn’t take an economist, rather basic logic, to understand that the solution to and cause of a problem cannot be the same. As any good financial analyst knows, a company in distress needs to reduce leverage and restructure before it can expect to grow again.
5 While Treasury Secretary Robert Rubin was the official spokesman for this policy, recall that his Assistant Secretary, and eventual successor, was Larry Summers, who is thought by some to have been the true architect of the policy. Currently, Mr Summers is a senior advisor to President Obama, whereas Treasury Secretary Geithner is the official spokesman for the dollar. He claims that the US wants a strong dollar. How this is compatible with calls for China to revalue its exchange rate is unclear, but at least consistent, with other Orwellian aspects of current US economic policy rhetoric.
7 A simple way to understand why bank valuations are highly sensitive to interest rates is to consider what banks in effect are: large, diversified pools of financial assets, primarily loans. As such, the discount rate applied to those assets is going to have a direct impact on their net present value (NPV).
8 While the so-called “special relationship” between the US and UK precludes any open disagreement over economic policy, we can imagine that Westminster’s aggressive fiscal consolidation and power devolution plans are not going over well in Washington, which is moving quite clearly in the opposite direction on both counts. Indeed, the UK is even planning substantial cuts to the military budget, something which seems to be a complete taboo for both major parties in the US.